Rethinking Corporate Liquidity Management Post-Basel III

The new requirements for banks in a post-Basel III world have been covered extensively; they include more and better quality of capital, appropriate levels of stable liquidity, matching of long term assets with liabilities and the need to manage pricing to account for the increased capital, liquidity and leverage requirements. But given the symbiotic nature of relationships between banks and corporates, what are the repercussions for their clients? 

As banks come under pressure to be more vigilant in their use of capital and maximise their return on equity (RoE) they will, inevitably, be more expensive to run. This will have a knock-on impact for corporates, increasing the price for certain banking services. Just as banks have done, corporates need to adapt to a post-Basel III era and to do so will mean taking a fresh look at cash pooling and even the operating relationship with their bank. 

Reviewing Cash Pooling 

Notional Pooling – A costly proposition?: Cash pooling has for many years been an effective means for corporates to optimise their intergroup funding. This is typically achieved through cash sweeping or notional pooling services provided by banks. 

Cash sweeping involves the physical movement of funds between participating entities. Entities with a shortfall are funded by those with surplus funds, resulting in inter-company loans. The treatment, in terms of tax and accounting, is straightforward and unambiguous. 

Notional pooling, on the other hand, works on the basis that corporates can notionally ‘offset’ a negative cash position in one participating entity, using an equivalent positive cash position in another participating entity – and all without actual fund movement. In this scenario, corporates benefit from not incurring any bank overdraft charges on the negative cash position without having to create any intercompany loans. For this option to be commercially viable for a bank, certain conditions need to be met that will allow the bank to achieve a reduction in capital allocation associated with risk-weighted assets (RWA) created by the negative cash position. Without this the negative cash position will be treated as an overdraft, which it is accompanied by very unattractive RWA treatment for the bank.

The conditions for reducing RWA vary for different banks depending on their governing central bank, but the most prevalent condition is the need for a legally enforceable right of set-off. This means that in the event of bankruptcy of a notional pool participant, the bank has the operational controls and legal right to withhold the balances held in the account. 

Establishing the legal right is an arduous task, especially when dealing with notional pools with participants from multiple jurisdictions. Three levels of validation would be necessary. Firstly, the pooling location law permits set-off. Secondly the jurisdiction of incorporation of each participating entity permits set-off in the event of bankruptcy. Finally, each participant’s articles of incorporation and resolutions enable them to provide cross guarantees necessary to support the set-off arrangement. This process can be costly and time-consuming, both for the bank and the corporate.

With Basel III, most banks are taking a hard look at how they can optimise their RWA in order to achieve the requisite core Tier 1 ratio without having to raise capital through further rights issues. Products with high RWA consumption will certainly be the first area to be looked at. In terms of the continued provision of notional pooling by banks, there can be several scenarios as a result: 

  • Banks may only include entities where there is a clear enforceable right of set-off. 
  • Banks may price up notional pooling services in order to cover the higher costs associated with the RWA and legal review requirements. 
  • Banks may have to look at the credit grade of their clients, and selectively provide the service those of higher creditworthiness. 
  • Banks may cap the extent of offset permissible in the notional pool. 

The most likely outcome is a combination of all of the above.  

Corporate Considerations: Ultimately for a corporate entering into a notional pool arrangement, this has to bring quantifiable value – be it in terms of balance sheet management, interest optimisation or working capital efficiency (WCE).With the anticipated changes, it is almost certain that the value proposition to the corporate will be diluted to a certain extent. A corporate will likewise have to assess the respective costs and benefits of remaining or entering into a notional pool arrangement. 

In addition to the Basel III knock-on impact to the corporate, another related area of consideration is the accounting treatment for notional pools. Under the International Financial Reporting Standards (IFRS) IAS 32 prescribed rules for the offsetting of financial assets and financial liabilities, a financial asset and a financial liability should be offset and the net amount reported when – and only when – a corporate:

  • Has a legally enforceable right to set-off the amounts. 
  • Intends to either settle on a net basis, or to realise the asset and settle the liability simultaneously.

If the above conditions are not met, entities entering into a notional pool agreement can no longer report the net amount of the pool, but will have to present ‘gross’ debit and credit balances in their entities’ balance sheets. Interest paid and earned will also have to be presented separately in the profit and loss (P&L). Balance sheet ratios, such as return on capital (RoC) and solvency ratios may be affected as a result. The last point is pertinent for companies with financing agreement or loan covenants negotiated based on these ratios, and should take into account the impact of the accounting treatment on these agreements. The US generally accepted accounting principles (GAAP) accounting standard also has similar criteria for offsetting.

Further considerations for corporates in their review of notional pooling arrangements include the following: 

Exploring alternative solutions: Cash sweeping, due to its clearer tax and accounting treatment, can be a good alternative to notional pooling to the extent it meets the corporate’s objectives. While the net interest optimisation impact is similar to notional pooling, it does create intercompany loans that need to be managed differently. For instance, the reallocation of interest between the entities will be treated as intercompany interest, and subject to intercompany withholding tax. This differs from notional pooling, where interest re-allocation is generally treated as bank interest and which can have a very different withholding tax outcome.

Balance sheet netting: To adhere to the IFRS netting requirements for notional pooling, a corporate will need to settle the outstanding asset and liability periodically. This means that any overdrawn account has to be replenished by the surplus in other accounts for a certain period acceptable to the corporate’s auditor, after which the original balances will be restored. This effectively creates a ‘sweeping within a notional pool’, where intercompany loans are created for the period where the settlement has to occur to satisfy the offsetting requirement. It is also worth noting that the right of set-off requirement is also aligned with the bank’s requirement for RWA reduction. So the tedious legal validation process discussed earlier is a necessity, not only for banks but also for the corporate.

Exploring alternative service providers: As banking regulations tighten, banks will be adopting the more stringent directives by different degrees and at different paces, as governed by their central banks. This environment creates an uneven playing field where a bank – not necessarily constrained by rules which make notional pooling expensive – can step up their marketing in this area and provide notional pooling services more competitively. The considerations for corporates will be: firstly how the potential alternative service provider measures up in terms of counterparty risk and banking services both provided historically and also moving forward; and secondly whether the conditions set forth by these banks are aligned with the corporate’s own accounting standards requirement as discussed in the previous point. 

Reviewing Operating Relationship 

Basel III introduces a Liquidity Coverage Ratio (LCR) aimed at addressing the sufficiency of high quality assets to meet short-term liquidity outflows under a specified 30 day stress scenario. It is already evident that banks are now focusing much more on the quality of client deposits that they onboard. In short, quality deposits are those that tend to be sticky and have a higher probability of remaining with the bank in the event of market or bank stress. This makes client balances tied to strong operating activities much more attractive to banks than, say, a short-dated time deposit from a client with no other activities performed through the bank. 

In terms of corporate liquidity management, corporates could benefit from reviewing their overall cash and investment portfolio, and evaluate how they might be able to rebalance the placement of their cash and investments to optimise risk, returns and liquidity. Counter to the recent trend of risk diversification by placing cash in multiple banks, this might mean having to select fewer key strategic banking partners able to cater to their full spectrum of operating/transactional flows; (for example cash payments, collection, trade finance), cash pooling and short and long-dated investment needs. 

Corporate liquidity management in a post-Basel III world can be a difficult landscape to navigate. Considerations have changed considerably on both sides of the corporate and bank equation and relationships have evolved and will continue to do so. However, change, in this situation, does come with its potential benefits.

Companies with a firm grasp of bank counterparty risk and well-capitalised banks should find few obstacles to build symbiotic partnerships in a post-Basel III world, where depth of relationship feeds better capital utilisation for the banks, which in turn will be more likely to recognise and reward their clients with superior terms and services. 

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